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Monday, 9 March 2009

What Is Quantitative Easing?

As it is the topic of the day, I thought you may like to see this explanation. It is kindly provided by Peter Kelly of Pegasus Funding a finance brokerage specialising in providing financing options for SME's in the UK.

What is quantitative easing?

Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates.

Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, their only option is to pump money into the economy directly. That is quantitative easing.

The way the central bank does this is by buying up assets - usually financial assets such as government and corporate bonds - using money it has simply created out of thin air.

The institutions selling those assets (either commercial banks or other financial businesses such as insurance companies) will then have "new" money in their accounts, which theoretically should boost the money supply.

How would it work?

Even economists who agree with the quantitative easing policy often disagree on how exactly it will work. But there are two main ways it could boost the economy, which are really two sides of the same coin.

The first channel is through the direct effect on the banks' bank accounts. With more money sloshing about in their accounts, the banks may decide to lend more to businesses and individuals, and increase the amount of activity in the economy that way.

The second channel is through the effect on the cost of borrowing. When the Bank buys bonds, it reduces the supply of those bonds in the economy. That should increase the demand for new bonds and, at the same time, make it cheaper for businesses to borrow.

Having taken very short-term interest rates as low as possible, the idea would be for the Bank to push down longer-term rates as well (which are the rates that companies and individuals borrow at).

Are there any risks?

Quantitative easing is a high-risk strategy. If it is not done aggressively enough, banks will remain unwilling to lend and the crisis could drag on. To some extent that is what happened in Japan when this was tried 10 years ago.

Like old-fashioned money printing, QE also runs the risk of going too far: pumping too much money into the economy and causing high inflation - even hyperinflation - as seen in 1920s Weimar Germany and modern-day Zimbabwe.

But in those cases, the government was printing money simply to pay the government's bills. They were not responding to the risk of deflation as the Bank of England is today.

Is this printing money?

Of course, these days the Bank of England doesn't have to literally print money to do QE. It's all done electronically.

However, economists would still argue however that QE is the same principle as printing money as it is a deliberate expansion of the central bank's balance sheet and the monetary base.

Why is it different from Weimar and Zimbabwe?

Printing money can be defined as the central bank financing of government debts. This is what happened in both Weimar and Zimbabwe and what the British government will insist it is not doing, although the short-term effect is similar.

According to the Maastricht Treaty, EU member states are not allowed to finance their public deficits by printing money. That is one reason why the Bank of England will buy government bonds from financial institutions, not directly from the government.

The Bank believes this form of QE is different because they are "printing money" as part of monetary policy - to prevent deflation. They are not printing money to help the government finance its deficit. Also, unlike Zimbabwe, this is a temporary policy: the Bank expects to sell the government bonds back into the market when the economy recovers.

How do we know if it has worked?

If QE works, credit growth will pick up and businesses will find it easier to get credit. That, in turn, should help stimulate the economy and help push inflation back up to the Bank of England's target figure of 2%, thus staving off the threat of deflation.